Containing economic volatility
Following the global financial crisis of the late 2000s, much effort was devoted to retrospectively determining causes and drivers. Overnight volatility emerged as an important factor fuelling economic instability. The EU-funded project 'Overnight volatility in financial markets: Causes and consequences' (OVERNIGHT VOLATILITY) studied the effects of the phenomenon on monetary transmission. The goal was to determine the effectiveness of crisis-containing policies of American and European central banks. Project research involved a year-long visit at the United States' Federal Reserve.The rate volatility of US federal funds is associated with high risk premium, and contributed to elevated spread of the London InterBank Offered Rate–overnight index swap in the period 2007 to 2009. The project compared the effects of non-standard policies adopted by the Federal Reserve and the European Central Bank (ECB) during the crisis. The work led to quantification of the policy impact on bank loans, showing a lowering of volatility and sustained loan supply. Further study developed a measure for money market stress in the United States, showing distinct phases of low, high and extreme stress. It was concluded that phase-switches corresponded to Federal Reserve action intended to reduce stress. During the crisis, stress levels generally remained low. A study of banks in the United States showed that institutions receiving Term Auction Facility funds increased their loan allocation, while those receiving Troubled Assets Relief Program funding did not. In terms of large-scale asset purchases, the project found that the Federal Reserve mainly buys from a few investor types, typically households. The result favours the 'preferred-habit' theory and the idea that monetary policy transmission works across asset markets. Finally, OVERNIGHT VOLATILITY examined the effect of political commentary. Commentaries affect policy rate expectations in Europe, but there is no evidence suggesting that the Federal Reserve responds to commentaries.The project's broad conclusion was that overnight volatility plays an essential inhibitory role in monetary transmission during financial crises. Thus, central banks need policy mechanisms to avoid volatility, with such Federal Reserve and ECB policies proving effective during the crisis.
Keywords
Federal Reserve, central bank, policy mechanism, overnight volatility, monetary transmission, financial crisis
